Understanding Derivatives to Understand the Credit Crisis

Like it or not we hear the term “derivatives” bandied about in the mainstream financial press these days with increasing regularity.

In recent times it has come to be a term that, when mentioned in conjunction with a particular financial institution, can cause loss of confidence or worse, maybe a herd-like run on deposits [or policies] on the offending institution.

To help clear up some of the confusion, today's market wrap will deal with Derivatives: where they came from and how they've morphed into the reviled bank-killers they are known as today.

Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Credit derivatives have become an increasingly large part of the derivative market.

In the Beginning

From the definition above, one can surmise that when one speaks of “derivatives,” they are usually referring to the “wrap” or encapsulation of specific financial products known futures, forwards, options and swaps.

From an historical context , it was agricultural commodities futures [mainly grain] that first gained traction as viable financial instruments. The genesis of these products dates back to the founding of the Chicago Board of Trade [CBT] in the mid-eighteen hundreds.

The need for agricultural futures stemmed from the fact that, prior to the inception of agri-futures, farming was generally perceived as being risky [draught, weather, etc.] and NOT bankable due to the boom-bust nature of prices of agricultural products.

Agricultural commodities futures and developments such as crop insurance, essentially transformed farming [remember, we were a much more agrarian economy back in the 1800's] into a massive, bankable, line of business. This development allowed banks to transfer the risks associated with weather / boom-bust commodities prices off their balance sheets to speculators who better understood and were willing to accept these risks. In technical jargon:

Futures markets have three fundamental purposes. The first is to enable hedgers to shift price risk – asset price volatility – to speculators in return for basis risk – changes in the difference between a futures price and the cash, or current spot price of the underlying asset. Because basis risk is typically less than asset price risk, the financial community views hedging as a form of risk management and speculating as a form of risk taking.

This process of transferring risk also helped “free up capital” or space on bank's balance sheets - to finance other pursuits in a rapidly industrializing society.

In the beginning [1800's] the CBT's role was more of a broker, marrying individual farmers, who would sell their anticipated production forward to a willing counterparty at an agreed price for a fee. While effective at disseminating risk, this process was still fraught with counter-party risk.

It was not until the 1920's when futures trading had evolved to the point where the CBT itself became the Clearing House for the commodities it transacted with the introduction of standardized, uniform contracts. This meant that the buyer and seller of any commodity future now bought and sold directly with the exchange [CBT] – removing counter-party risk [by posting margin] from commodities transactions.

Explosive Growth

The growth of derivatives markets [futures trading] really began to take-off during the 1960's, with expanded agricultural commodities offerings, and 1970's with the introduction and proliferation of futures [forwards] on foreign exchange in the wake of President Nixon taking the U.S. Dollar off the gold standard in August of 1971.

By the late 1970's the first interest rate derivatives [Eurodollar Futures] were conceived and began trading. As the interest rate futures market gained traction, ancillary markets like Interest Rate Swaps sprung to life :

Misinformation regarding the origin and genesis of the OTC Interest Rate Derivatives complex abound in the market.

During the 1970's – after President Nixon took the world off the gold standard - the dramatic increase in the price of crude oil led to burgeoning balances of petro dollars [Euro-dollars] in the treasuries of banks involved in international trade. This immediately led to banks bolstering their treasury operations to deal with the influx of ‘inflated dollars'.

In the beginning these petro-dollar balances were strictly lent or borrowed in the inter-bank market.

Interest Rate Derivatives were initiated by the establishment [around 1980] of the four 3-month IMM Eurodollar Futures Contracts [Dec, Mar, Jun, Sept] on the Chicago Mercantile Exchange [CME]. These contracts settled against 3 month libor [London Interbank Offered Rate] for Eurodollar Time Deposits on the third Wednesday of the contract month. The 3 month libor rate is ‘set' daily by a group of banks selected by the British Bankers Association and represents where these ‘reference banks' are willing to ‘loan' their mostly recycled Euro Dollar [petro-dollar] as 3 month time deposits.

The advent of these 3 month Euro-dollar futures gave banks the ability to ‘hedge' or book profits on sizable amounts of predictable future cash flows emanating from ongoing business. But the business remained – while burgeoning – largely a cash trade.

In 1980, Canada revised it's Bank Act. In the ensuing few months, with the influx of foreign banks [dubbed schedule B banks] – Canada went from having 5 domestic banks to having roughly 65 banks. To protect their home turf, the existing domestic banking industry successfully lobbied the politicos to limit the amount of capital new ‘schedule B' banks could have [initially to 5 or 10 million]. This placed a straight jacket on foreign banks now operating in Canada; capital ceilings implied severe balance sheet restrictions. So a situation had developed where 60 new banks had just opened their doors – but were effectively frozen out [balance sheet limitations] of participating in ‘main stream' bank treasury operations [lending long – borrowing short - in the inter-bank market].

These treasury operations needed to find a raison d'etre [a road to profitability] in a hurry or their parent banks would shut them down.

Competition Breeds Innovation

To differentiate themselves from the rest of the crowd back in the early 1980's, institutions like Citibank, Toronto and Chemical Bank, Toronto went on a hiring binge of Ph.D mathematician types and immersed themselves in ‘financial engineering' utilizing then emerging exchange traded futures [cited above].

It was Citibank, Toronto or Chemical Bank, Toronto who did the very first Inter-bank U.S. Dollar Interest Rate Derivative – known as an FRA [Future Rate Agreement] which, at its core – is nothing more than a glorified ‘bet' on what 3, 6 or 12 month libor will be at a future date. I know this because I was an institutional broker and Citibank, Toronto was my client. Soon after [or simultaneously] the first FRA's were done – Citibank Toronto had engineered a model to successfully book profits from interest rate swaps.

In the very beginning – these trades were ENORMOUSLY profitable – so much so that Citbank Toronto very quickly became – hands-down -the world's biggest OTC interest rate derivatives house and was, in fact, the clearing house for OTC interest rate derivatives for Citibank worldwide.

What this innovation allowed banks to do – was make the same bets on the interest rate curve as the cash players – without ever risking the principal AND it was all off balance sheet – therefore avoiding the balance sheet restrictions.

This business absolutely mushroomed!

Somewhere along the line – like the late 1980's – folks in New York took notice that they were losing their grip on the pulse of the money market and institutions like Citibank Toronto had their ‘books' repatriated back to New York. I watched all of this happen – first hand.

By this time, folks at institutions like J.P. Morgan and Bankers Trust [later merged/bailed out by Deutshe Bk.] realized that these products – utilized in sufficient size – could effectively give an institution control of interest rates.

Pre-Conditions That Set the Stage

In today's marketplace, institutional abuse on the part of players like J.P. Morgan and their 93 Trillion in notional derivatives book have categorically been utilized to subvert what would otherwise be free market rates of interest [through their obscene use of interest rate swaps]. This is all documented and explained in, The Invisible Hand and the Pox Known as Usury .

What folks need to understand is this; historically market rates of interest are set at roughly [+] 250 basis points over the real rate of interest:

Real Rate of Interest = Nominal Rate – Inflation

By understating the inflation rate [falsifying inflation data], we end up with higher reported Real Rates of Interest [positive nominally] – when in fact, real returns are negative. The misreporting of inflation has been well documented and reported through the work of John Williams at www.Shadowstats.com . Negative real rates of interest over a protracted number of years have resulted in a low or negative savings rate and countless episodes of speculative economic excess – EXACTLY as Elementary Economics 101 would suggest.

Dislocations we are now experiencing are the result of “infinite” creation [by virtue of it being un-backed] of money colliding with the reality that we live in a finite world. The process we now know as Globalism accelerated the process and again shone light on the inadequacy of un-back, irredeemable fiat currency.

This fundamental mis-pricing of capital [through falsification of inflation data] was originally conceived as a means to help the most indebted entity in the world – the U.S. Government – cover its inflation indexed entitlement spending programs.

From an historic and fundamental perspective, this mis-pricing of capital would naturally lead to a continuous rise in the gold price. Therefore, suppression of the gold price necessarily had to go hand-in-hand with the falsification of inflation data.

Unintended Outcomes Due to the Falsification of Inflation Data

The short term assist to U.S. Government finances gained through the mis-pricing of capital only exacerbated economic abuses on a number of fronts. Perhaps most importantly, it served to promote the financialization of our economy to the point where financial engineering [ponzi shell games with off-balance sheet gimmicks] became BIG BUSINESS unto itself.

After all, with capital being so severely mis-priced, money was free!!

As this metamorphosis continued, it required the complicity of all the self serving players; government, bankers, regulators and ESPECIALLY the ratings agencies. If the raters of debt had performed the function they were set up to do – PROPERLY AND IMPARTIALLY RATE DEBT – the cancerous sub-prime, CDO fraud would have been stillborn – period.

But that did not happen.

Instead, the cancer was allowed – heck, encouraged - to grow and spread.

Where We Are Today

Most people intuitively understand that cancer, left untreated, usually kills the host. Well, the toll that this financial cancer has exacted on the U.S. Dollar and its standing as the World's Reserve Currency may well end up being fatal.

Empirically, we are now suffering the deleterious effects of capital which is fundamentally mis-priced:

As evidenced by futures-derived Libor Rates, which are supposed to be representative of where banks are willing lenders of money – but no longer properly reflect bank's true cost of funds. We see this expressed in the mainstream as the TED SPREAD being “blown out” [expressed in basis points] to extreme levels.

As evidenced by futures-derived Libor Rates, which are supposed to be representative of where banks are willing lenders of money – but no longer properly reflect bank's true cost of funds. We see this expressed in the mainstream as the TED SPREAD being “blown out” [expressed in basis points] to extreme levels.

As evidenced by erroneous futures prices for precious metal, which are supposed to be representative of where one can actually purchase the underlying physical commodity.

In the case of precious metals pricing today; the cost of procuring physical precious metal has radically decoupled from the fraudulently derived futures price of the same. In a conversation I had with one of Canada's largest physical, retail bullion dealers last Friday – here's a summary of what he told me:

As a long time and valued customer of the Royal Canadian Mint, he has been told that the Mint is not accepting ANY orders for gold or silver coin for at least 3 months – and no guarantees then either.

Gold:

- There are zero one ounce gold bars in North America at wholesale – period.

- Same thing for 10 oz gold bars.

- Some kilo gold bars are available at wholesale but in highly limited supply at prices starting at 5% over spot [COMEX price].

- He is currently receiving a couple of hundred calls per day for small gold [one ounce denominations] and has no product to sell.

Silver:

- He told me there are ZERO one thousand ounce bars available at wholesale in the U.S.A and `supply of the same in Canada is HIGHLY limited.

- He laughed when I mentioned that there was supply at COMEX and he told me COMEX was a JOKE. He told me he doesn't price silver using COMEX [silver futures prices] any more – he looks at prices being paid on E-Bay instead.

- He is currently getting 50 calls a day for silver and has no product to sell.

Prognosis

Until monetary authorities come clean and admit what has truly occurred in our Capital Markets – aka a PROPER DIAGNOSIS – proposed remedies will have little effect and may even kill the patient.

Today's Market

Overseas equity markets began the week on a positive note with Japan's Nikkei Index gaining 311 points to close at 9,005. North American markets also improved with the DOW ahead by 413.20 to 9,265.40, the NASDAQ adding 58.74 to 1,770.03 and the S & P up 44.85 to 985.40. NYMEX crude oil futures gained 2.65 to close at 74.50 per barrel.

On foreign exchange markets the U.S. Dollar Index gained .65 to close at 83.02.

Interest rates were marginally lower with the benchmark 5 yr. bond finishing the day at 2.80% while the 10 yr. note ended the day at 3.85%.

Precious metals improved across the board with COMEX gold futures adding 13.60 to 797.30 per ounce while COMEX silver futures gained .47 to 9.85 per ounce. The XAU Index added 9.21 to 95.06 while the HUI Index gained 19.21 to close at 222.81.

Rob Kirby is the editor of the Kirby Analytics Bi-weekly Online Newsletter, which provides proprietry Macroeconomic Research. Subscribers to Kirbyanalytics.com are benefiting from paid in-depth research reports, analysis and commentary on rapidly unfolding economic developments as well as recommendations on courses of action to profit from chaos. Subscribe here .

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors before engaging in any trading activities.

Comments

David G. Gowing
23 Oct 08, 21:21

Non linear derivatives mispriced by Academic world of finance

1996 the CBOE stopped giving data on options to academics and sent a threatening letter to those who already received data. The letter stated that if the data already given was shared with any other academic(s) the recipient of the data would be sued.

Why? Over the last >25 years less than 10% of options expire in the money (ITM) and this < 10% ITM has a negative yield (the payoff is less than the premium paid).

If options where priced properly, over the long term 50% would expire ITM and this 50% would have a negative yield (this being proper compensation for those who short the options and are perceived to take the greater risk.

Non-linear derivative securities are a ponzy scheme that provides near risk-less arbitrage profits for the extremely wealthy. If you do not believe me, try and write 100 options as an individual (not covered calls etc) just write the options naked.

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